6.

Bottoms: The Agony and the Opportunity I'll admit that the last chapter is a bit disingenuous. You can only identify a bubble after it bursts. This was particularly true of the 1920s. From January 1920 to September 1929, the market's total return (dividends included) was an astonis.h.i.+ng 20% per year. As sure as night follows day, should not a bust follow such a boom? And yet, as we've already seen, the market's precipitous rise was accompanied by strong economic fundamentals, suggesting a sound basis for the run-up. Further, similar near-20% returns have also occurred during other ten-year periods: from 1942 to 1952, 1949 to 1959, and 1982 to 1992. But none of these was followed by a crash.

Just as markets periodically suffer bouts of mania and gross overvaluation, so too do they regularly become absurdly despondent. Just as investors must deal rationally with irrational exuberance, they must also be able to handle pervasive gloom. The Great Internet Bubble will not be the last of its kind, but if history is any guide, we should not see anything approaching it until the next generation of investors takes leave of its senses, sometime around the year 2030. If the current generation gets caught out again, we should be very disappointed, as no previous generation has been so dense as to have been fooled twice. But then again, the Boomers have shown a singular talent for gullibility, and there is still plenty of time.

Of more immediate relevance to the long-term investor is the possibility of a period of low returns and pervasive pessimism. We've implicitly dealt with this in the second chapter when we examined the low estimate of future stock returns calculated from the Gordon Equation. On a more basic level, it is a simple mathematical fact that high past returns reduce future returns. In general, a high purchase price is not a good thing. And if expected returns are low, then the laws of statistics tell us that a severe downturn becomes more likely. In other words, if the expected return is 6% instead of 11%, normal variation about a lower average return will make the bad years look even worse.

One concept that is ignored by even the most sophisticated financial players is that over the long haul, risk and return become the same thing. Optimists will point out that there has never been a 30-year period in which stocks returned less than bonds. But this is simply because stocks have averaged 6% more return than bonds. Given this yearly advantage, it is almost impossible to string together 30 years in which stocks will not win. In other words, the long-term apparent safety of stocks was due to a combination of high stock returns, powered partially by 5% dividends, and low bond returns, due to unexpected inflation. Neither of these factors is likely to be present in the future. If the expected return of stocks is only 1% or 2% more than bonds, then because of random variability, the 30-year dominance of stocks over bonds is no longer a sure thing.

And even if stocks do maintain their 6% advantage over bonds-an extremely unlikely event, in my view-they can still underperform safer a.s.sets for very long periods, as happened from 1966 to 1983 when they underperformed both Treasury bills and inflation. Imagine: 17 years with zero real stock returns.

What we'll do in this short chapter is to take a look at what it's like to live and invest through such a period. Unless you were actively investing in stocks in 1966, you will benefit from a description of what the investment equivalent of 40 miles of bad road felt like. And even if you were around then, it doesn't hurt to be reminded.

Although each of the bubbles described in the last chapter was followed by a terrible bear market, we're only going to cover some of them, and not in exact sequence. We will, however, deal with the look and feel of these grim periods in a general way, exploring the reasons why they occur. We'll even formulate a set of "reverse Minsky criteria" for busts, which are the mirror image of those required for a bubble. And, finally, we'll muse over the societal and legislative reactions to these periods.

"The Death of Equities"

Readers of BusinessWeek BusinessWeek were greeted with a cover story t.i.tled "The Death of Equities" in August 1979, and few had trouble believing it. The Dow Jones Industrial Average, which had toyed with the 1,000 level in January 1973, was now trading at 875 six and a half years later. Worse, inflation was running at almost 9%. A dollar invested in the stock market in 1973 now purchased just 71 cents of goods, even allowing for reinvested dividends. With the kind permission of McGraw-Hill, I quote extensively from this morbid portrait of a market bottom: were greeted with a cover story t.i.tled "The Death of Equities" in August 1979, and few had trouble believing it. The Dow Jones Industrial Average, which had toyed with the 1,000 level in January 1973, was now trading at 875 six and a half years later. Worse, inflation was running at almost 9%. A dollar invested in the stock market in 1973 now purchased just 71 cents of goods, even allowing for reinvested dividends. With the kind permission of McGraw-Hill, I quote extensively from this morbid portrait of a market bottom: The ma.s.ses long ago switched from stocks to investments having higher yields and more protection from inflation. Now the pension funds-the market's last hope-have won permission to quit stocks and bonds for real estate, futures, gold, and even diamonds. The death of equities looks like an almost permanent condition-reversible someday, but not soon.

The contrast in the mood evoked above with today's investment mindset cannot be more divergent. Diamonds, gold, and real estate? Most certainly. The price of the yellow metal had risen from $35 per ounce in 1968 to more than $500 in 1979 and would peak at over $800 the following year. Just as today, everyone's neighbors have gotten rich in the stock market, 20 years ago the wise and lucky had purchased their houses for a song with 6% mortgages and by 1980 were sitting on real capital wealth beyond their wildest dreams. Stocks and bonds? "Paper a.s.sets," sneered the conventional wisdom. The article continued: At least 7 million shareholders have defected from the stock market since 1970, leaving equities more than ever the province of giant inst.i.tutional investors. And now the inst.i.tutions have been given the go-ahead to s.h.i.+ft more of their money from stocks-and bonds-into other investments. If the inst.i.tutions, who control the bulk of the nation's wealth, now withdraw billions from both the stock and bond markets, the implications for the U.S. economy could not be worse. Says Robert S. Salomon Jr., a general partner in Salomon Brothers:"We are running the risk of immobilizing a substantial portion of the world's wealth in someone's stamp collection."

This excerpt refers to an interesting phenomenon. In the late 1960s, more than 30% of households owned stock. But by the 1970s and early 1980s, the number of stockholding families bottomed out at only 15%. It began to rise again, slowly at first, and then with the stock market's increasing popularity, more rapidly. Currently, it stands at more than 50% of all households.

Next, the very idea that stocks might themselves be a wise investment was attacked: Further, this "death of equity" can no longer be seen as something a stock market rally-however strong-will check. It has persisted for more than 10 years through market rallies, business cycles, recession, recoveries, and booms. The problem is not merely that there are 7 million fewer shareholders than there were in 1970. Younger investors, in particular, are avoiding stocks. Between 1970 and 1975, the number of investors declined in every age group but one: individuals 65 and older. While the number of investors under 65 dropped by about 25%, the number of investors over 65 jumped by more than 30%. Only the elderly who have not understood the changes in the nation's financial markets, or who are unable to adjust to them, are sticking with stocks.

After reading the last chapter, you should be able to grasp the sublime irony of this pa.s.sage. Did the elderly stick with stocks in 1979 because they were out of step, inattentive, or senile? No! They were the only ones who still remembered how to value stocks by traditional criteria, which told them that stocks were cheap, cheap, cheap. They were the only investors with experience enough to know that severe bear markets are usually followed by powerful bull markets They were the only ones who still remembered how to value stocks by traditional criteria, which told them that stocks were cheap, cheap, cheap. They were the only investors with experience enough to know that severe bear markets are usually followed by powerful bull markets. A few, like my father, even remembered the depths of 1932, when our very capitalist system seemed threatened and stocks yielded near 10% in dividends.

The opposite generational phenomenon occurred in 2001. The Internet Bust hit the singles apartments much harder than it did the retirement centers. The 1979 article ended by adding insult to injury: Today, the old att.i.tude of buying solid stocks as a cornerstone for one's life savings and retirement has simply disappeared. Says a young U.S. executive: "Have you been to an American stockholders' meeting lately? They're all old fogies. The stock market is just not where the action's at."

The point of this exercise is not just to point out how markets can go to extremes (a valuable lesson in and of itself) but to demonstrate several more salient points. First, it is human nature to be unduly influenced by the last 10 or even 20 years' returns. It was just as hard to imagine that U.S. stocks were a good investment in 1979 as it is to imagine that precious metals, emerging markets, and Pacific Rim stocks are now.

Second, when recent returns for a given a.s.set cla.s.s have been very high or very low, put your faith in the longest data series you can find-not just the most recent data. For example, if the BusinessWeek BusinessWeek article had explored the historical record, it would have found that nominal stock returns from 1900 to 1979 were 6% more than inflation. article had explored the historical record, it would have found that nominal stock returns from 1900 to 1979 were 6% more than inflation.

Third, be able to estimate returns for yourself. At the time that the article was written, stocks were yielding more than 5% and earnings were continuing to grow at a real rate of 2% per year. Anyone able to add could have calculated a 7% expected real return from these two numbers. The subsequent real return was actually 11% because of the extraordinary increase of valuations typical of recoveries from bear markets.

Finally, do not underestimate the amount of courage it takes to act on your beliefs. As I've already mentioned, human beings are profoundly social creatures, and buying a.s.sets that everyone else has been running from takes more fort.i.tude than most investors can manage. But if you are equal to the task, you will be well rewarded.

Ben Graham Goes Out on a Limb The 1920s and its aftermath left Benjamin Graham deeply perplexed: How could so many have been so wrong for so long? After the cataclysm, why should any reasonable investor ever buy stocks again? And if so, what criteria should she use for their selection? The result was his ma.n.u.script, Security a.n.a.lysis Security a.n.a.lysis, a dense, beautifully written brick of a book, produced during the depths of the Depression. In it, Graham put his finger on just what went wrong and how a reasonable person should approach both stocks and bonds in the future. It is still considered a cla.s.sic. (It went through many later editions. If you ever get bitten by the Graham bug and decide to read it, make sure you purchase McGraw-Hill's reproduction of the original 1934 edition, unless, of course, you can afford several thousand dollars for an original copy. Later editions were increasingly influenced by his co-authors David Dodd, Sidney Cottle, and Charles Tatham, who did not write nearly as well.) By the time Security a.n.a.lysis Security a.n.a.lysis was published, the investing public had almost completely abandoned stocks. Most agreed with the leading economist of the time, Lawrence Chamberlain, who, in his widely read book, was published, the investing public had almost completely abandoned stocks. Most agreed with the leading economist of the time, Lawrence Chamberlain, who, in his widely read book, Investment and Speculation Investment and Speculation, flatly stated that only bonds were suitable for investment. This att.i.tude persisted for nearly three decades. As late as 1940, a survey by the Federal Reserve Board found that 90% of the public expressed opposition to the purchase of common stocks.

Graham, as he always did, approached things from first principles. What was investing?

An investment operation is one which, upon thorough a.n.a.lysis promises safety of princ.i.p.al and an adequate return. Operations not meeting these requirements are speculative.

Was Graham able to find suitable stock investments in 1934? Most definitely. Graham introduced a wonderful amoral relativism to investing: there were no intrinsically "good" or "bad" stocks. At a high enough price, even the best companies were highly speculative. And at a low enough price, even the worst companies were a sound investment.

Graham recommended that even the most conservative investors hold at least 25% of their portfolios in common stocks, with the most aggressive investors holding no more than 75%. The implication was that the average investor should hold a 50/50 split between stocks and bonds. Although tame by today's standards, in the depths of the depression, recommending any stock owners.h.i.+p at all was a startling piece of advice.

What did the market look like in 1932? Prices were so low that the dividend yield was nearly 10%, and remained above 6% for more than a decade. Almost all stocks sold for less than their "book value" (roughly, the total value of their a.s.sets), and fully one-third of all stocks sold for less than one-tenth of their book value! (By comparison, today, the average S&P 500 stock sells at about six times book value.) In short, stocks could not be given away, even at these prices. Anyone paying good money for them was considered certifiable.

The aftermath of the Nifty Fifty and the bear market of 19731974 is equally instructive. By the end of 1974, the average stock sold at seven times earnings, and fully one-third of those companies could be bought at cheaper than five times earnings. Even the high-fliers of the Fifty themselves-the crown jewels of American industry-were on fire sale. McDonalds, which had been selling at a P/E of 83 in 1972, could be bought at a P/E of 9 as late as 1980. During the same period, the P/E of Disney had fallen from 76 to 11; Polaroid, from 90 to 16; and Hewlett-Packard, from 65 to 18.

The rewards of fis.h.i.+ng in such troubled waters are staggering. For the 20 years following the 1932 bottom, the market returned 15.4% annually, and for the 20 years following the 1974 bottom, 15.1% annually.

We don't have such precise data on the aftermath of the earlier bubbles, but it was no doubt just as dramatic. South Sea shares, for example, fell about 85% from their peak. Although the other great public companies were not as badly hit, stock prices still dropped significantly. Shares in the East India Company fell about 60%, while those of the Bank of England fell 40%. The later collapse in prices of the English railroad and ca.n.a.l companies was even more severe.

The societal effects of the collapses varied from episode to episode. Certainly, aside perhaps from a bit of "malaise," to use President Carter's unfortunate wording, the 19731974 decline had relatively little long-term impact on the U.S. On the other hand, the Federal Reserve's mishandling of the liquidity crunch brought on by the 1929 crash magnified its effects, resulting in the Great Depression, which scarred the national psyche for decades.

The collapse of railroad shares in 1845 was equally catastrophic; a worldwide depression nearly swept away the Bank of England. Only hard money retained its value. The most long-lasting effect of the railway mania is that Britain, to this day, is cursed with a disorganized bramble of a rail network. Even casual visitors cannot help but notice the contrast with France's more efficient layout, which was first surveyed by military engineers and then let out for private construction bids.

Minsky's criteria for bubbles work just as well in reverse with busts. A generalized loss in the faith of the new technologies to cure the system's ills is usually the triggering factor. A contraction of liquidity almost always follows, with the losses of faith and liquidity reinforcing each other. The third criterion is an amnesia for the recoveries that usually follow collapses. And finally, investors incapable of doing the math on the way up do not miraculously regain it on the way down. Cheap stocks excite only the dispa.s.sionate, the a.n.a.lytical, and the aged.

But by far, the most fascinating aftermath of crashes is the political and legal kabuki that often follows. Financial writer Fred Schwed astutely observed that, "The burnt customer certainly prefers to believe that he has been robbed rather than that he has been a fool on the advice of fools." History shows that when an entire nation has acted unwisely on bad advice, the rules of the game are likely to change drastically, and that the sources of that advice should beware.

The political reaction to the South Sea Bubble was violent. Many of the company's directors, including four MPs, were sent to the Tower. Most of their profits were confiscated, despite the fact that such a seizure of a.s.sets was a violation of common law. No one cared about such niceties, and the directors were lucky to escape with their lives. The legislative repercussions from the South Sea episode haunted the English capital markets for nearly two centuries thereafter. The Bubble Act, which had actually precipitated the collapse, required a parliamentary charter for all new companies.

Aside from wasting Parliament's time and energy, the Bubble Act mainly served to hinder the formation of new enterprises. Parliament almost outlawed stockbrokering and made illegal short sales, futures, and options. These devices serve to make the capital markets more liquid and efficient, and their absence undoubtedly served to make subsequent crises more difficult to manage. The railway mania itself is a case in point; had investors been able to sell short railway shares, the bubble and subsequent collapse would likely have been much less violent.

A similar reaction occurred in the United States in the wake of the 1929 crash that should give pause to many involved in the most recent speculative excess. At the center of this t.i.tanic story was a brilliant attorney of Sicilian origin, Ferdinand Pecora. Just before the market bottom in 1932, with embittered investors everywhere demanding investigation of Wall Street's chicanery, the Senate authorized a Banking and Currency Committee. It promptly hired Pecora, then a New York City a.s.sistant district attorney, as its counsel. In the following year, he skillfully guided the committee, and via it the public, through an investigation of the sordid ma.s.s of manipulation and fraud that characterized the era. The high and mighty of Wall Street were politely but devastatingly interrogated by Pecora, right up to J.P. "Jack" Morgan, scion of the House of Morgan and a formidable figure in his own right.

But the real drama centered around New York Stock Exchange President Richard Whitney. Tall, cool, and aristocratic, he symbolized the "Old Guard" at the stock exchange, who sought to keep it the private preserve of the member firms, free of government regulation.

In the drama of the October 1929 crash, Whitney was the closest thing Wall Street had to a popular hero. At the height of the bloodshed on Black Thursday-October 25, 1929-he strode to the U.S. Steel post and made the most famous single trade in the history of finance: a purchase of 10,000 shares of U.S. Steel at 205, even though at that point it was trading well below that price. This single-handedly stopped the panic.

But d.i.c.k Whitney was a flawed hero. His arrogance in front of the committee alienated both the legislators and the public. He was also a lousy investor, with a weakness for c.o.c.kamamie schemes and an inability to cut his losses. He wound up deeply in debt and began borrowing heavily, first from his brother (a Morgan partner), then from the Morgan Bank itself, and finally from other banks, friends, and even casual acquaintances. In order to secure bank loans, he pledged bonds belonging to the exchange's Gratuity Fund-its charity pool for employees. This final act would be his downfall.

Under almost any other circ.u.mstances, he would not have been treated harshly for this transgression. But Whitney had found himself at the wrong place at the wrong time. In 1935, he went to Sing Sing. He was not the only t.i.tan of finance who found himself a guest of the state, however, and many of the most prominent players of the 1920s met even more ignominious ends.

The moral for the actors in the recent Internet drama is obvious. When enough investors find themselves shorn, scapegoats will be sought. Minor offenses, which in normal times would not attract notice, suddenly acquire a much greater legal significance. The next Pecora Committee drama already seems to be shaping up in the form of congressional inquiries into the Enron disaster and brokerage a.n.a.lyst recommendations. It is likely that we are just seeing the beginning of renewed government interest in the investment industry.

On the positive side, four major pieces of legislation came out of the Pecora hearings. Unlike the post-bubble English experience, the committee's effect was positive; three new laws were introduced that still shape our modern market structure. The Securities Act of 1933 made the issuance of stocks and bonds a more open and fair process. The Securities Act of 1934 regulated stock and bond trading and established the SEC. The Investment Company Act of 1940, pa.s.sed in reaction to the investment trust debacle, allowed the development of the modern mutual fund industry. And finally, the Gla.s.s-Steagall Act separated commercial and investment banking. This last statute has recently been repealed. Sooner or later, we will likely painfully relearn the reasons for its pa.s.sage almost seven decades ago.

This legislative ensemble made the U.S. securities markets the most tightly regulated in the world. If you seek an area where rigorous government oversight contributes to the public good, you need look no further. The result is the planet's most transparent and equitable financial markets. If there is one industry where the U.S. has lapped the field, it is financial services, for which we can thank Ferdinand Pecora and the rogues he pursued.

How to Handle the Panic What is the investor to do during the inevitable crashes that characterize the capital markets? At a minimum, you should not panic and sell out-simply stand pat. You should have a firm a.s.set allocation policy in place. What separates the professional from the amateur are two things: First, the knowledge that brutal bear markets are a fact of life and that there is no way to avoid their effects. And second, that when times get tough, the former stays the course; the latter abandons the blueprints, or, more often than not, has no blueprints at all.

In the book's last section, we'll talk about portfolio rebalancing-the process of maintaining a constant allocation; this is a technique which automatically commands you to sell when the market is euphoric and prices are high, and to buy when the market is morose and prices are low.

Ideally, when prices fall dramatically, you should go even further and actually increase your percentage equity allocation, which would require buying yet more stocks. This requires nerves of steel and runs the risk that you may exhaust your cash long before the market finally touches bottom. I don't recommend this course of action to all but the hardiest and experienced of souls. If you decide to go this route, you should increase your stock allocation only by very small very small amounts-say by 5% after a fall of 25% in prices-so as to avoid running out of cash and risking complete demoralization in the event of a 1930s-style bear market. amounts-say by 5% after a fall of 25% in prices-so as to avoid running out of cash and risking complete demoralization in the event of a 1930s-style bear market.

Bubbles and Busts: Summing Up In the last two chapters, I hope that I've accomplished four things.

First, I hope I've told a good yarn. An appreciation of manias and crashes should be part of every educated person's body of historical knowledge. It informs us, as almost no other subject can, about the psychology of peoples and nations. And most importantly, it is yet one more demonstration that there is really nothing new in this world. In the famous words of Alphonse Karr, Plus ca change, plus c'est la meme chose Plus ca change, plus c'est la meme chose: The more things change, the more they stay the same.

Second, I hope I have shown you that from time to time, markets can indeed become either irrationally exuberant or morosely depressed. During the good times, it is important to remember that things can go to h.e.l.l in a hand basket with brutal dispatch. And just as important, to remember in times of market pessimism that things almost always turn around.

Third, it is fatuous to believe that the boom/bust cycle has been abolished. The market is no more capable of eliminating its extreme behavior than the tiger is of changing its stripes. As University of Chicago economics professor d.i.c.k Thaler points out, all finance is behavioral. Investors will forever be captives of the emotions and responses bred into their brains over the eons. As this book is being written, most readers should have no trouble believing that irrational exuberance happens. It is less obvious, but equally true, that the sort of pessimism seen in the markets 25 and 70 years ago is a near certainty at some point in the future as well.

And last, the most profitable thing we can learn from the history of booms and busts is that at times of great optimism, future returns are lowest; when things look bleakest, future returns are highest. Since risk and return are just different sides of the same coin, it cannot be any other way.

PILLAR THREE.

The Psychology of Investing.

The a.n.a.lyst's Couch.

The biggest obstacle to your investment success is staring out at you from your mirror. Human nature overflows with behavioral traits that will rob you faster than an unlucky nighttime turn in Central Park.

We discovered in Chapter 5 Chapter 5 that raw brainpower alone is not sufficient for investment success, as demonstrated by Sir Isaac Newton, one of the most notable victims of the South Sea Bubble. We have no historical record of William Shakespeare's investment returns, but I'm willing to bet that, given his keen eye for human foibles, his returns were far better than Sir Isaac's. that raw brainpower alone is not sufficient for investment success, as demonstrated by Sir Isaac Newton, one of the most notable victims of the South Sea Bubble. We have no historical record of William Shakespeare's investment returns, but I'm willing to bet that, given his keen eye for human foibles, his returns were far better than Sir Isaac's.

In Chapter 7 Chapter 7, we identify the biggest culprits. I guarantee you'll recognize most of these as the face in the looking gla.s.s. In Chapter 8 Chapter 8, we'll devise strategies for dealing with them.

7.

Misbehavior The investor's chief problem-and even his worst enemy-is likely to be himself.

Benjamin Graham d.i.c.k Thaler Misses a Basketball Game The major premise of economics is that investors are rational and will always behave in their own self-interest. There's only one problem. It isn't true. Investors, like everyone else, are most often the hapless captives of human nature. As Benjamin Graham said, we are our own worst enemies. But until very recently, financial economists ignored the financial havoc wreaked by human beings on themselves.

Thirty years ago, a young finance academic by the name of Richard Thaler and a friend were contemplating driving across Rochester, New York, in a blinding snowstorm to see a basketball game. They wisely elected not to. His companion remarked, "But if we had bought the tickets already, we'd go." To which Thaler replied, "True-and interesting." Interesting because according to economic theory, whether or not the tickets have already been purchased should not influence the decision to brave a snowstorm to see a ball game.

Thaler began collecting such anomalies and nearly single-handedly founded the discipline of behavioral finance-the study of how human nature forces us to make irrational economic choices. (Conventional finance, on the other hand, a.s.sumes that investors make only rational choices.) Thaler has even extended his research to basketball itself. Why, he wonders, do players usually go for the two-point shot when down by two points with seconds remaining? The two-point percentage is about 50%, meaning that your chance of winning is only 25%, since making the goal only serves to throw the game into overtime. A three-point shot wins the game and has a better success rate-about 33%.

At about the same time in the early 1970s that Thaler and his friend were deciding whether or not to brave the snowstorm, two Israeli psychologists, Daniel Kahneman and Amos Tversky, were studying the imperfections in the human decision-making process in a far sunnier clime. They published a landmark paper in the prestigious journal Science Science, in which they outlined the basic errors made by humans in estimating probabilities. A typical riddle: "Steve is very shy and withdrawn, invariably helpful, but with little interest in people, or in the world of reality . . ." Is he a librarian or mechanic? Most people would label him a librarian. Not so: there are far more mechanics than librarians in the world, and plenty of mechanics are shy. It is therefore more likely that Steve is a mechanic. But people inevitably get it wrong.

The Kahneman-Tversky paper is a cla.s.sic, but it is unfortunately couched in an increasingly complex series of mind-twisting examples. Its relevance to investing is not immediately obvious. But Thaler and his followers were able to extend Kahneman and Tversky's work to economics, founding the field of behavioral finance. (Thaler himself dislikes the label. He asks, "Is there any other kind of finance?") This chapter will describe the most costly investment behaviors. It is likely that at one time or another, you have suffered from every single one.

Don't Get Trampled by the Herd Human beings are supremely social animals. We enjoy a.s.sociating with others, and we particularly love sharing our common interests. In general, this is a good thing on multiple levels-economic, psychological, educational, and political. But in investing, it's downright dangerous.

This is because our interests, beliefs, and behaviors are subject to fas.h.i.+on. How else can we explain why men wore their hair short in the 1950s and long in the 1970s? Why bomb shelters were all the rage in the early 1960s, then fell into disuse in later decades, when the number of thermonuclear weapons was exponentially greater? Why the pendulum between political liberalism and conservatism swings back and forth to the same kind of generational metronome as stocks and bonds?

The problem is that stocks and bonds are not like hula hoops or beehive hairdos-they cannot be manufactured rapidly enough to keep up with demand-so their prices rise and fall with fas.h.i.+on. Think about what happens when everyone has decided that, as happened in the 1970s and 1990s, large growth companies like Disney, Microsoft, and Coca-Cola were the best companies to own. Their prices got bid to stratospheric levels, reducing their future return. This kind of price rise can go to absurd lengths before a few brave souls pull out their calculators, run the numbers, and inform the populace that the emperor has no clothes.

For this reason, the conventional investment wisdom is usually wrong. If everyone believes that stocks are the best investment, what that tells you is that everyone already owns them. This, in turn, means two things. First, that because everyone has bought them, prices are high and future returns, low. And second, and more important, that there is no one else left to buy these stocks that there is no one else left to buy these stocks. For it is only when there is an untapped reservoir of future buyers that prices can rise.

Everyone Can't Be Above Average In a piece on investor preconceptions in the September 14, 1998, issue of The Wall Street Journal The Wall Street Journal, writer Greg Ip examined the change in investor att.i.tudes following the market decline in the summer of 1998. He tabulated the change in investor expectations as follows: [image]

The first thing that leaps out of this table is that the average investor thinks that he will best the market by about 2%. While some investors may accomplish this, it is, of course, mathematically impossible for the average investor to do so. As we've already discussed, the average investor must, of necessity, obtain the market return, minus expenses and transaction costs. Even the most casual observer of human nature should not be surprised by this paradox-people tend to be overconfident.

Overconfidence likely has some survival advantage in a state of nature, but not in the world of finance. Consider the following: * In one study, 81% of new business owners thought that they had a good chance of succeeding, but that only 39% of their peers did.* In another study, 82% of young U.S. drivers considered themselves in the top 30% of their group in terms of safety. (In self-doubting Sweden, not unsurprisingly, the percentage is lower.) The factors a.s.sociated with overconfidence are intriguing. The more complex the task, the more inappropriately overconfident we are. "Calibration" of one's efforts is also a factor. The longer the "feedback loop," or the time-delay, between our actions and the results, the greater our overconfidence. For example, meteorologists, bridge players, and emergency room physicians are generally well-calibrated because of the brief time span separating their actions and their results. Most investors are not.

Overconfidence is probably the most important of financial behavioral errors, and it comes in different flavors. The first is the illusion that you can successfully pick stocks by following a few simple rules or subscribing to an advisory service such as Value Line. About once a week, someone emails me selection criteria for picking stocks, usually involving industry leaders, P/E ratios, dividend yields, and/or earnings growth, which the sender is certain will provide market-beating results.

Right now, if I wanted to, with a few keystrokes I could screen a database of the more than 7,000 publicly traded U.S. companies according to hundreds of different characteristics, or even my own customized criteria. There are dozens of inexpensive, commercially available software programs capable of this, and they reside on the hard drives of hundreds of thousands of small and inst.i.tutional investors, each and every one of whom is busily seeking market-beating techniques. Do you really think that you're smarter and faster than all of them?

On top of that, there are tens of thousands of professional investors using the kind of software, hardware, data, technical support, and underlying research that you and I can only dream of. When you buy and sell stock, you're most likely trading with them them. You have as much chance of consistently beating these folks as you have of starting at wide receiver for the Broncos.

The same goes for picking mutual funds. I hope that by now I've dissuaded you from believing that selecting funds on the basis of past performance is of any value. Picking mutual funds is a highly seductive activity because it's easy to find ones that have outperformed for several years or more by dumb luck alone. In a taxable account, this is especially devastating, because each time you switch ponies you take a capital gains haircut.

There are some who believe that by using more qualitative criteria, such as through careful evaluation and interviewing of fund heads, they can select successful money managers. I recently heard from an advisor who explained to me how, by interviewing dozens of fund managers yearly and going to Berks.h.i.+re shareholder meetings to listen to Warren Buffet, he was able to outperform the market for both domestic and foreign stocks. The only problem was that his bond, real estate, and commodities managers were so bad that his overall portfolio results were far below that of an indexed approach. Take another close look at Figure 3-4 Figure 3-4. If the nation's largest pension plans, each managing tens of billions of dollars, can't pick successful money managers, what chance do you think you have?

Most investors also believe that they can time the market, or worse, that by listening to the right guru, they will be able to. I have a fantasy in which one morning I slip into the Manhattan headquarters of the major brokerage firms and drop truth serum into their drinking water. That day, on news programs all over the country, dozens of a.n.a.lysts and market strategists, when asked for their prediction of market direction, answer, "How the h.e.l.l should I know? I learned long ago that my predictions weren't worth a darn; you know this as well as I. The only reason that we're both here doing this is because we have mouths to feed, and there are still chumps who will swallow this stuff!"

At any one moment, by sheer luck alone, there will be several strategists and fund managers who will be right on the money. In 1987, it was Elaine Garzarelli who successfully predicted the crash. Articulate, well-dressed, and flamboyant, she got far more media attention than she deserved. Needless to say, this was the kiss of death. Her predictive accuracy soon plummeted. Adding insult to injury, her brokerage house put her in charge of a high-profile fund that subsequently performed so badly that it was quietly killed off several years later.

The most recent guru-of-the-month was Abby Joseph Cohen, who is low-key, self-effacing, and, for a market strategist, fairly scholarly. (Her employer, Goldman Sachs, which emerged from the depths of ignominy in 1929 to become the most respected name in investment banking, makes a habit of hiring only those with dazzling math skills.) From 1995 to 1999, she was in the market's sweet spot, recommending a diet high in big growth and tech companies. Unfortunately, she didn't see the bubble that was obvious to most other observers, and for the past two years, she's been picking the egg off her face.

Remember, even a stopped clock is right twice a day. And there are plenty of stopped clocks in Wall Street's canyons; some of them will always have just shot a spectacular bull's-eye purely by accident.

There are really two behavioral errors operating in the overconfidence playground. The first is the "compartmentalization" of success and failure. We tend to remember those activities, or areas of our portfolios, in which we succeeded and forget about those areas where we didn't, as did the advisor I mentioned above. The second is that it's far more agreeable to ascribe success to skill than to luck.

The Immediate Past Is Out to Get You The next major error that investors make is the a.s.sumption that the immediate past is predictive of the long-term future. Take a look at the data from the table at the beginning of the chapter and note that in September 1998, after prices had fallen by a considerable amount, investors' estimates of stock returns were lower lower than they were in June. than they were in June.

This is highly irrational. Consider the following question: On January 1, you buy a gold coin for $300. In the ensuing month the price of gold falls, and your friend then buys an identical coin for $250. Ten years later, you both sell your coins at the same time. Who has earned the higher return? Most investors would choose the correct answer-your friend, having bought his coin for $50 less, will make $50 more (or at worst, lose $50 less) than you. Viewed in this context, it is astonis.h.i.+ng that any rational investor would infer lower expected returns from falling stock prices. The reason for this is what the behavioral scientists call "recency"; we tend to overemphasize more recent data and ignore older data, even if it is more comprehensive.

Until the year 2000, with large growth stocks on a tear, it was very difficult to convince investors not to expect 20% equity returns over the long term. Blame recency. Make the recent data spectacular and/or unpleasant, and it will completely blot out the more important, if abstract, data.

What makes recency such a killer is the fact that a.s.set cla.s.ses have a slight tendency to "mean-revert" over periods longer than three years. Mean reversion means that periods of relatively good performance tend to be followed by periods of relatively poor performance. The reverse also occurs; periods of relatively poor performance tend to be followed by periods of relatively good performance. Unfortunately, this is not a sure thing. Not by any means. But it makes buying the hot a.s.set cla.s.s of the past several years bad odds.

Let's look what happens when you fall victim to recency. In Table 7-1 Table 7-1, I've picked six a.s.set cla.s.ses-U.S. large and small stocks, as well as U.K., continental European, j.a.panese, and Pacific Rim stocks-and a.n.a.lyzed their performance at five-year intervals during the period from 1970 to 1999.

From 1970 to 1974, the top performer was j.a.pan; but in the next period, from 1975 to 1979, it ranked fourth. In those years, the best performer was U.S. small stocks, which actually did best from 1980 to 1984. But during the next period, from 1985 to 1989, it ranked last. The best performer from 1985 to 1989 was again j.a.panese stocks, but from 1990 to 1994 it ranked last. In that period, the best performer was Pacific Rim stocks, which ranked next to last from 1995 to 1999. The best a.s.set cla.s.s in the late 1990s was U.S. large-cap stocks, and, if the past two years is any indication, it seems likely to be near the bottom of the heap next time around.

Table 7-1 Subsequent Performance of Prior Best-Performing a.s.set Cla.s.ses Subsequent Performance of Prior Best-Performing a.s.set Cla.s.ses [image]

We've previously discussed how the recency illusion applies to single a.s.set cla.s.ses. For example, from 1996 to 2000, the return of j.a.panese stocks was an annualized loss loss of 4.54%, but over the 31 years from 1970 to 2000, it was 12.33%. Both inside and outside j.a.pan, investors have gotten very discouraged with its stock market in recent years. But which of these two values do you suppose is a more accurate indicator of its expected future return? of 4.54%, but over the 31 years from 1970 to 2000, it was 12.33%. Both inside and outside j.a.pan, investors have gotten very discouraged with its stock market in recent years. But which of these two values do you suppose is a more accurate indicator of its expected future return?

Likewise, the 1996 to 2000 return for the S&P 500 was 18.35%, but the very long-term data show a return of about 10%. Again, which of these two numbers do you think is the better indicator?

Entertain Me If indexing works so well, why do so few investors take advantage of it? Because it's so boring. As we discussed in Chapter 3 Chapter 3, at the same time that you're ensuring yourself decent returns and minimizing the chances of dying poor, you're also giving up the chance of striking it rich. It doesn't get much duller than this.

In fact, one of the most deadly investment traits is the need for excitement. Gambling may be the second-most enjoyable human activity. Why else do people throng to Las Vegas and Atlantic City when they know that, on average, they'll return lighter in the wallet?